Intel: What's With All The Fab Space?

I was fortunate enough to receive a very interesting set of questions about Intel (NASDAQ:INTC) in my inbox today. They were so good, and I had seen a number of them frequently asked elsewhere, that I decided that it would be helpful to my readers for me to dedicate an article to answering them! I remind all of my readers/followers that they are always more than free to send questions to my inbox about the companies that I cover. If it's a simple question, then I'll respond to you directly, but with a set of questions (or one that I believe will be of great interest to the followers of the stock), I am more than happy to answer them more formally in a full piece.

Without further ado, here are the questions!

Why was revenue so superb in 2011 and 2012 compared to prior years? How much did McAfee and Infineon contribute to the growth?

So back in 2010, Intel acquired McAfee, one of the world's leading anti-virus/security companies for roughly $7.6B. This is probably the most controversial acquisition in the company's history as many fail to understand just why Intel would drop such a huge amount of cash here. The acquisition probably happened for a couple of reasons:

It is an additional revenue/profit stream (to boost the top & bottom lines).

The tight integration of security at the hardware level was/is expected to allow Intel's processors to be much more secure than competing solutions and a big selling point for business/enterprise customers.

In terms of earnings reports, McAfee (along with a few other acquisitions) as "Software and Services," as shown here:

In 2011, this division contributed $1.87B to the topline and in 2012, this grew to $2.3B. It, as shown above, produced a slight net losses (so shareholders aren't going to see their money back on this one anytime soon).

Next, we have the Infineon Wireless acquisition which closed in early 2011. This division became part of Intel's Mobile and Communications (MCG), which is reported as part of the "Other Intel Architecture Group" in the SEC filings. To get a feel for its impact on revenue, here is the revenue/operating income data for that division:

We can see a roughly ~$2B jump from 2010 to 2011, so assume that the impact of the Infineon Wireless acquisition is about ~$2B/yr. Note that the division's operating losses widened post-acquisition in 2011 and widened still in 2012. The revenue weakness in 2012 from 2011 is due primarily to netbook sales falling off of a cliff, and operating loss widened due primarily to higher operating costs (R&D for modems, next-gen low power processor/SoCs, etc.).

So the answer to that question is that Infineon added ~$2B to the topline.

The next question is the following:

Why is Intel taking excess capacity charges? Why do they invest in more fabs when they are currently running at only 50% utilization?

Well, the answer to this one is pretty simple: Intel built out capacity for demand that never materialized. See, 1H 2012 started out pretty good, with solid Y/Y revenue increases over the same periods in 2011. It looked as though the trend would continue throughout the year, and as a result, Intel built out appropriate capacity to fill the projected demand.

As the story goes, the demand didn't materialize in Q3, so all of the inventory built out (this answers the question about Intel's high inventories) in anticipation of $14.2B - $14.8B in sales just wasn't consumed. Part of this was caution on the side of the PC vendors who wanted to keep their own inventories leaner than normal going into the uncertain Windows 8 launch, but part of it was simply that demand wasn't there for PCs.

The 50% utilization is a way for Intel to cut back its inventories. While the company takes non-cash excess capacity charges this way, it is better than taking write-downs on inventory that was built (this helps cash flow but dings net income). This is not expected to be permanent, and according to CFO Stacy Smith, the company expects the charges to be completely gone by Q2. This implies that factory utilization springs back to the ~90% level (Intel always leaves room for upside demand surprises).

Now, how do they get to that level of utilization by Q2 and beyond? Simple. The company will be undergoing a massive product refresh cycle that will be evident by 2H 2013, which means buildout needs to begin by Q2 2013. The new products that are coming include:

Intel expects a 10-15% Y/Y growth in the server processor space (likely driven by unit volume as pricing is as good as it gets), which certainly means more units. A refresh of the PC with "Haswell" should enable compelling battery life and form factor improvements, which should boost PC sales and bring units back up slightly. Presence in tablets is also pure upside from here.

So you've got more server chips, more PC chips, a 22nm refresh of the tablet products, and perhaps even a further ramp in smartphone chip volume. All of these combined should drive unit growth and, as a result, keep the fabs utilized.

The final question is,

Why did data-center units actually contract by 1% Y/Y from 2011?

There was strong growth in the cloud and networking segments (high double-digit), but this was offset by weakness in the traditional enterprise/IT space. The cloud and networking should continue to grow during 2013, which even in a flat enterprise/IT environment, should help to boost sales significantly. However, with a refresh in the big iron Xeon EX (the current one was launched in 2011 and is based on a 2 generation old architecture) coupled with the continued ramp of the "Romley" platform (and a refresh of the processors there), demand here should also pick up, barring some severe worsening of the macroeconomic situation.

Further, Intel sells $0.50 of non-processor components for every $1.00 of processors it sells into the data center (SSDs, networking, etc.), so revenue growth in the data center group should be amplified significantly by Intel's continued vertical integration of all thing data center related.

Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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